Brazil's central bank hikes more than expected, signals more tightening ahead

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Brazil raises interest rates by 100 basis points to 12.25%

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Benchmark rate could soar to 14.25% as early as March based on guidance

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Government spending package fell short of expectations

(Adds context in paragraph 2, comments from economists in paragraphs 7-9, inflation forecasts in paragraphs 17-18)

By Marcela Ayres

BRASILIA, Dec 11 (Reuters) - Brazil's central bank raised interest rates by a greater-than-expected 100 basis points on Wednesday and pointed to matching hikes for the next two meetings, signaling a shift to a new government-named governor will not weaken its determination to battle inflation.

If the proposed roadmap is followed, the benchmark borrowing rate could soar to 14.25% as early as March - more than an eight-year high - reflecting policymakers' determination to curb rising inflation expectations amid robust economic activity, a tight labor market and a weaker currency.

The bank's rate-setting committee, known as Copom, unanimously increased the benchmark Selic rate to 12.25%, noting a recent government-announced package of budget measures had impacted Brazil's real currency, asset prices and inflation expectations.

The highly-anticipated spending cut package from President Luiz Inacio Lula da Silva's administration fell short of expectations, straining confidence in the government's ability to manage the rising public debt?.

"The committee judges that these impacts contribute to more adverse inflation dynamics," said policymakers in the decision statement, the last under governor Roberto Campos Neto's leadership at the central bank.

Campos Neto, who will be succeeded in January by the current monetary policy director, Gabriel Galipolo, had been emphasizing that a positive fiscal shock, such as less government spending, would have a significant impact on markets if it changed the outlook for Brazil's public debt, as interest rate futures have surged amid growing fiscal concerns.

"Our interpretation is that the statement was quite harsh, with explicit guidance for at least another 200 basis points," said Alexandre Espirito Santo, chief economist at Way Investimentos.

While he deemed the committee's actions appropriate, he noted that managing expectations is an extremely challenging task at the moment, with focus shifting to the central bank's incoming leadership in January.

Jose Francisco Goncalves, chief economist at Fator, said "the Copom's choice for a shock approach reintroduces the additional risk of fiscal dominance, as the only guarantee for now is the increase in interest expenses."

In so-called fiscal dominance, central bank rate hikes increase government debt servicing costs and worsen fiscal conditions, deteriorating market expectations and ultimately driving inflation higher.

Policymakers began tightening in September, stressing that the overall magnitude of the cycle would be determined by the firm commitment to reaching the 3% inflation target - a message that remained unchanged on Wednesday.

Only four of 40 economists surveyed in a recent Reuters poll had anticipated a hike this size, while the majority had projected a smaller 75 basis-point increase.

But bets embedded on the yield curve already pointed to a steeper full percentage-point hike, which had not been seen since May 2022, following a sharp weakening of the currency after the fiscal package was unveiled.

The Brazilian real has depreciated nearly 20% year-to-date against the U.S. dollar, among the worst emerging market performances.

Minutes before the rate decision, policymakers announced plans to hold a U.S. dollar auction with a repurchase agreement of up to $4 billion on Thursday.

The view that the central bank should adopt a more hawkish stance gained momentum after the bank's weekly survey of economists showed a sharp deterioration in expectations for consumer prices extending into 2027.

This occurred despite expectations for a more aggressive tightening cycle, reflecting a loss of confidence in interest rates effectively curbing inflation.

The central bank itself revised on Wednesday its inflation estimates, now projecting inflation of 4.9% this year, up from 4.6% previously, and 4.5% in 2025, up from 3.9%.

For the second quarter of 2026, which is part of a 18-month horizon affected by current monetary policy decisions, it forecast annual inflation of 4.0%, up from the prior 3.6%. (Reporting by Marcela Ayres; Editing by Franklin Paul and Jamie Freed)